Volatility Index or VIX was launched as a distinct product in the Indian markets a few years back. This concept of VIX was launched on the Chicago Board and this Nifty VIX has been largely adapted from there. The VIX is also known as the Fear Index because a higher level of VIX normally reflects higher level of fear prevailing in the market. That is the reason market crashes are preceded by a sharp spike in the VIX or immediately followed by a sharp spike in the VIX. On the other hand, when the VIX is subdued below the 15 mark for a sustained period of time, it is a signal that downsides in the market are largely limited. The chart below captures the relative movement of the Nifty and the VIX over the last 2 years..
As the chart above clearly indicates, there is an inverse relationship between the Nifty and the VIX. Quite obviously being a fear index, the VIX is negatively correlated with the markets. Any market correction is accompanied by a sustained rise in the VIX just as long periods of uptrend in the market are accompanied by subdued levels of VIX.
Basis for VIX calculation..
To under VIX we need to go back briefly and understand how the value of an option is calculated. The value of an option is impacted by the following factors:
Time to expiry
Probably, the most important of these components is volatility as it measures the risk of the option. When you buy an option you have the right but not the obligation to buy or sell a stock. Hence volatility is always positive for options values. If the volatility is positive then you gain from the price increase. But if volatility is negative your losses are still limited to the extent of premium paid. That is why volatility positively impacts the value of call and put options.
In the traditional Black & Scholes Model, the volatility is the input and value of the option is the output. For calculating the VIX we slightly twist this around. The market price of the option becomes the option value and the volatility is the unknown factor. When the volatility is calculated using the Black & Scholes formula in reverse, the figure that you get is called implied volatility. If you want to see how the implied volatility of an option varies when the market price of the option changes, you can use an option value calculator.
How is the VIX number arrived at?
Now that you have learnt how to calculate the implied volatility, the next step is to identify the complete option chain for the index (Nifty). For calculating the VIX, only out-of-the-money (OTM) options are considered. That is because the price of an OTM option is entirely time value. In case of ITM options you have intrinsic value and time value combined. This leads to double counting and hence VIX calculates only for the OTM options. When the IVs of all the strikes are considered together and averaged you get the VIX. That is how the VIX is calculated on a real time basis.
How to use VIX to take a view on equity markets..
VIX is a very good measure of risk perception of the markets. When you see VIX going up sharply then you can be certain that volatility expectations of the market are going up sharply. That will typically mean that option values will also go up in tandem since both calls and puts move up in tandem with volatility expectations. From a strategic point of view this may be a good time to create long strangles on the Nifty.
There has been a consistently negative correlation between the VIX and the Nifty levels. The historical correlation ranges between (-0.80 and -0.85). This is indicative of a strong negative correlation. This enables you to trade a popular range for the VIX. For example, VIX has typically tended to bottom out around the 10-12 levels. So if the VIX has been consistent around these levels for a long time then you can safely assume that any negative geopolitical or economic trigger could sharply take the VIX up and the Nifty down. You can play the Nifty on the short side.
On the other hand, barring exceptional circumstances, the VIX has peaked around the level of 26-29. You can use these levels as indicator of bottoming out of the Nifty and you can appropriately initiate long positions around these levels.
At the heart, VIX reflects fear and the market always co-varies negatively with fear. That is the crux of the link between VIX and the Nifty index.